The sub prime crisis continues

by Business Case Studies on Monday 14th April, 2008

The sub prime crisis continues

The term 'sub prime mortgage' refers to a mortgage lent at a rate above the prime (market lending) rates. Sub prime refers to the credit status of the borrower – often persons with a poor credit history, who may find it difficult to obtain finance from traditional sources. These mortgages are also often used to consolidate existing secured and non-secured debts. A rise in defaults by sub prime borrowers in the US in 2007 resulted in the economic crisis which has recently shaken financial markets across the globe.

Opponents of sub prime lending claim that lenders deliberately lent to borrowers who were not able to meet the terms of their loans, thus leading to default, seizure of collateral and foreclosure. Supporters of sub prime lending maintain that the practice makes credit available to people who would otherwise not have access to it.

The ongoing lending and credit crisis in the United States in the sub prime and wider financial markets has led to a restriction on the availability of credit in world financial markets. As a result of the hundreds of thousands of borrowers forced to default on their mortgages, several US sub prime lenders have filed for bankruptcy. Central banks in the US and UK have been forced to inject cash into the banking system amid fears that the global economic growth will slow.

In the week commencing 17th March, Bear Stearns, America's fifth-biggest bank, was bought by its rival, JPMorgan, for $240 million – 3% of what it was worth the previous week. David Jones, the chief market strategist at IG Index, the spread-better, said: 'The problem is the unknown. If a major US investment bank is worth $60 a share a week ago and then $2 seven days later – what other skeletons are still to come out of the closet' (The Times, 18 March 2008)

British banks are exposed to the US crisis because they rely on wholesale markets to fund lending. Since the collapse of the US financial markets, this funding has virtually dried up.

Read the articles from The Times newspaper (references below) for up-to-date comment on the current credit crunch.

See also The Times 100 case study on HMRC, which shows that its role is vital for the government's control of the economy. This case study helps to illustrate how governments use both fiscal policy and monetary policy in order to meet their objectives. The UK economy changes year after year. The UK government seeks to achieve many policies including economic growth, improving the standard of living of people within the country, controlling inflation and reducing unemployment.

Sources:

The Times Online – High street banks hold out their begging bowls, 18th March 2008

The Times Online – Housing market: first-time buyers hit as lenders pull plug on all but the lowest-risk loans, 18th March 2008

The Times Online – Credit crunch: Don't expect to walk into a Georgian pile, 18th March 2008

The Times 100 Edition 12 Case Studies – HMRC, How HMRC collects tax revenue to support goverment policy

The Times 100 Edition 12 Theory pages – Economic conditions

The Times 100 Edition 12 Theory pages – Inflation

Potential Study Questions:

  • Explain the difference between monetary and fiscal policy.
  • What effect does a rise in the UK interest rate have on the exchange rat, and how does this affect imports/exports?
  • Explain the counter-cyclical policies employed by governments in (a) a recession and (b) a boom.

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